Leaving a job means dealing with 401(k)

When you leave a job, one of the decisions you need to make is what to do with your 401(k) account. Your options are to leave it with your former employer to manage (if the company allows this) or to roll it over into another retirement account. You can also take a cash distribution, which may or may not be wise, depending on your age and other factors.

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By Elliot Raphaelson

recordnet.com

By Elliot Raphaelson

Posted Jul. 29, 2012 at 12:01 AM

By Elliot Raphaelson

Posted Jul. 29, 2012 at 12:01 AM

» Social News

When you leave a job, one of the decisions you need to make is what to do with your 401(k) account. Your options are to leave it with your former employer to manage (if the company allows this) or to roll it over into another retirement account. You can also take a cash distribution, which may or may not be wise, depending on your age and other factors.

What should you do? I recommend comparing the performance and the costs of your 401(k) with other alternatives. If you are younger than 55, likely the best option is to convert the account into an individual retirement account. There are compelling reasons to do so: Most 401(k) plans have much higher recurring costs than many IRA alternatives. In addition, you can set up an IRA with a company that offers many more investment alternatives.

I believe that most investors are better off with a no-load mutual fund offered by companies such as Vanguard, Fidelity or T. Rowe Price. They have specialists to help investors avoid mistakes. The annual costs of their mutual funds tend to be much lower than the typical 401(k) management fees - probably by at least 1 percent of your investment balance.

Another option is to roll over your 401(k) account to a discount brokerage firm, if you are comfortable making your own investment decisions. You could establish a low-cost diversified portfolio using exchange-traded funds.

On the other hand, you could still utilize the ETF option with the major mutual fund companies. The overall costs of using a full-service broker are much higher, so only roll over a 401(k) account there if you have a history of success.

Cashing out is also an option, but you should avoid this if you are younger than 55. Not only will all your proceeds be taxable, but you will also face a 10 percent IRS penalty on all withdrawals.

Even if you are older than 55, consider a rollover. Income earned on your investments will be tax-deferred in an IRA. From age 591/2 to 701/2, you will have complete flexibility regarding withdrawals of both principal and interest. Only after 701/2 will you be required to make withdrawals. All withdrawals are subject to ordinary income taxes (except in Roth IRAs).

There is a scenario in which a rollover isn't the best idea. Let's say you are at least 55 and expect to need some of the money in your account before you reach age 591/2. You may want to wait to convert. Withdrawals can be made from a 401(k) without penalty at age 55; for IRAs the age is 591/2. If you convert immediately at 55 and withdraw from your IRA at 57, you will pay a penalty. If you leave the 401(k) alone, you can withdraw and only pay tax on the distributions.

If you roll over your account into an IRA, make sure you execute a direct rollover, so that the funds are transferred to the trustee of the new IRA and never deposited into your personal account. That is the surest way to avoid tax liability.

If you receive the check directly and subsequently deposit it into the new IRA, you will run into tax problems. Your former employer will probably withhold 20 percent of the withdrawal for tax purposes, leaving you with only 80 percent to deposit in your new IRA. If you don't deposit 100 percent into the new account - you must do this within 60 days - the remainder is treated as a taxable withdrawal, and if you are younger than 55, you will also pay a 10 percent penalty. Say, for example, that your account is valued at $100,000 and you receive $80,000 from your former employer and subsequently deposit it. You will owe taxes on the $20,000 the company withheld and have to pay a $2,000 penalty.

If you have borrowed from your 401(k) and the loan is outstanding at the time you leave the company, make every attempt to repay the loan, even if you have to borrow the money elsewhere to do so. Otherwise, the loan will be treated as a distribution, and you may have to pay a 10 percent penalty, depending on your age.

If your 401(k) contains employer stock that has increased in value, you may not want to roll it over. You may be better off moving it to a taxable account so you can have the gain treated as a capital gain rather than as ordinary income. Discuss this with your tax adviser.

Contact Elliot Raphaelson, a certified court mediator in Florida with experience in estate planning, at elliotraph@gmail.com.